Optimising only for profit is a lousy strategy

I felt sorry for the woman when I heard she was going to be let go by the company. I felt even more sorry when I heard that she would be replaced by 3 graduates in China. Seriously, graduates were that cheap in China?

This reminds me of a Chinese phrase. “In the past, having a degree was a big deal. Now, the whole street’s filled with graduates.” Not all degrees are created equal.

Let’s start off with a few baseline understandings…

Infinity and beyond

John Cook said this about infinity,

Problems are often formulated in terms of infinity to make things easier and to solve realistic problems. Infinity is usually a simplification. Think of infinity as “so big I don’t have to worry about how big it is.”

(Emphasis mine)

Companies like infinity. Particularly when it comes to describing (theoretical) growths and market share. This is false. More on this later.

Basic economics

We will assume this simple generalised equation for the purpose of this article:

Profit (or earnings) = Revenue – Cost

You can think of revenue as the price of an item. Cost covers everything from the cost of manufacturing an item to storing the item, to paying employees, to paying rent (for use of space), to paying utilities.

Just keep in mind that profit is calculated from 2 components.

The gold standard and Bretton Woods

Back in the old days (way way back), the value of money was static. If you held on to a dollar, 10 years later, that dollar was still worth a dollar. That’s because the value of money was tied to gold.

Historically, a bank was legally responsible to give anyone gold in exchange for the money bill given. That means if you handed the bank 100 dollars, the bank had to give you 100 dollars worth of gold. This meant that banks had to keep large reserves of gold, just in case.

The invention of the money bill dollar note thingy just made it easier so you don’t have to carry around nuggets of gold. Gold’s heavy.

In July 1944, the Bretton Woods Agreement was signed. Basically, many countries agreed to tie their currency to the US dollar. The US dollar was tied to the gold standard, so this wasn’t a problem. (This was part of the reason why US rose to be a dominant force in the world in the early days, because practically everyone was using the US dollar as a reserve currency)

In August 1971, the United States stopped the convertibility of the US dollar to gold. It might have something to do with funding the battles of the Vietnam War. The US ran out of funds. To continue funding, the US needed to print money out of thin air. And you couldn’t do that if your currency was pegged to gold. (Note: I’m not bashing on Americans. I read this in an economics book. No I can’t remember which book… you should know me by now…).

This also “freed” the other countries from tying their currencies to the US dollar. Which (probably) gave rise to the idea of foreign currency exchange rates.

The dissolution of the Bretton Woods Agreement also meant the creation of fiat money. Meaning that dollar you have there is worth what the government say it’s worth. Printing money out of thin air also gave rise to the concept of inflation. Meaning that dollar you have there is probably worth less than a dollar a year ago.

Saturation limits

31 October 2011 was designated as the day when the world population became 7 billion. It’s a big number, but it’s not infinity.

Which is where the companies made their mistake.

In the post-World-War-2 era, everyone wanted a better life. We’ve sacrificed enough. We’ve suffered enough. We want a better life! (baby boomers, hello!)

Babies were made. Population grew. Household appliances made their ways into homes. Henry Ford created the automobile. Product categories multiplied. Industries boomed.

Revenue was up. Sales quintupled. Profits were up.

Just when local markets seemed exhausted, globalisation came and opened up the world. International trade continued the seemingly upward trend.

People started expecting growth as a natural consequence. Companies started paying more attention to Wall Street and upholding shareholder value.

“We just need to capture 1 more percent of market share!”

That started to get harder. The customers who wanted to buy your product had already bought your product.

I read that in America, there were more licensed vehicles than licensed drivers. Meaning there were more vehicles than people who could drive them. I understand there’s a surplus of 31 million of such vehicles. Supposedly, every man, woman and child in Canada could have a vehicle from this surplus.

There are probably more cell phones than cell phone users. There’s more food produced than needed to feed every person in the world (yet there are millions starving).

What happens if Microsoft succeeds in placing a computer (with Windows, naturally) on every desktop and in every home? What happens if Apple succeeds in placing an iPhone/iPad in everyone’s hands? What if everyone has already bought Angry Birds on their iPhone/iPad? What happens if McDonald’s succeeds in getting everyone to eat at their restaurants? What if everyone used an Oral B toothbrush? What if everyone used Body Shop products? What if every male used Old Spice?

What if every business person is already flying with your airline? What if every Harry Potter fan already has all 7 books? (that’s probably a rhetorical question…) What if every C# programmer already owns a copy of your C# programming book? What if every tea lover in your area is already frequenting your tea house?

What if every possible customer already has your product? What if every possible customer already maxed out his/her rate of consumption of your product?

The natural limit is population. The next limit is rate of consumption. Every company hits these 2 limits. The limits just weren’t as prominent a couple of decades ago.

Revenue started stalling

When you hit those natural limits, the company growth stalls. To give the illusion of growth, we go back to that equation again.

Profit = Revenue – Cost

The outside world (mainly Wall Street and the stock market) views growth in relation to profit. The assumption is that if a company is making a profit, it’s still healthy. As in it’s still bringing in revenue.

But if you’re not bringing in revenue, it means you’re not making any more sales. Maybe it’s because your customers switched brands. Maybe your customers switched to a cheaper version of your product (which cannibalises on your own sales, but hey at least you didn’t lose that customer).

But in today’s hyperconnected world, the reason is probably that your customer “market share” is already saturated. You might think 7 billion people is still a lot of people, but a large part of those people are in poverty. They simply cannot buy your product. Or those who can buy your product, don’t want your product.

Some new startup shows up and gets millions of users within a month. It continues at a steady pace and then… stops. The natural equilibrium is reached.

The company CEO has to do something to show that the company is still growing (because the people watching Dow Jones is breathing down her neck). So if revenue doesn’t increase as much, what can you do to increase profits? Reduce costs.

Cost reduction policies

I’d say as a broad generalisation, there’s only so much you can do to reduce costs. Rent space? Consolidate people and equipment in fewer locations. Equipment maintenance costs? Have less equipment, or more efficient equipment, or just get rid of the whole thing.

But one of the most costly line items (if not the most costly) is hiring people. (Be honest. Tell me when I said “cost reduction” you didn’t think of “layoffs”)

Let’s see. The world population is growing (albeit more slowly now). Generally speaking, more people are working (I know the current economy sucks with few jobs being created. Stay with me). Less people are dying. More people are having longer lives. Less opportunities to move up the corporate ladder (because the high level managers are still there).

Yet people still expect pay raises every year. I’m not pro-Malthusianism, but the supply of money is kinda limited… Wait, good thing the Bretton Woods Agreement was dissolved.

Since people have feelings (and machines and raw materials don’t), companies hesitate to fire people (in case of major backlashes). So something has to give.

Outsourcing (the bad kind). Mergers and acquisitions (probably where the term “wholly owned subsidiary” came from). Subtle changes in accounting books (which is illegal, don’t do it).

Anything to create the illusion of growth and profits. (And with the fiat currency system, money itself is kind of an illusion. But that’s another topic…)

It’s made people commit suicide to make an iPhone. It’s made people to over-consume (creating obesity as a problem and the dieting industry to exist). It’s made people buy houses they couldn’t really afford. It’s made people to allow those people who couldn’t afford houses to buy houses.

It’s made people look for shallower qualities in marriage partners (diamonds, big car, big house, big breasts [I hesitated on including this one], big paycheck), which caused increasing divorce rates, which increased the number of divorce lawyers needed, which increased the number of real estate agents needed (to split the property).

It’s caused the dot com bust. It’s caused tech startups to look for the fastest exit strategy, because the venture capitalists backing the startup forced the founders to do so (so the VCs could get their return on investment).

Optimising only for profit is a lousy strategy.

Negative numbers in business reports

Some of my articles here aren’t what you call mainstream. They’re just different. I think a lot of them weren’t that big a deal, but it turns out some people find them useful. Here’s one that I get queries about: negative numbers in percentage calculations. The general question distills to: “There are some products, and one or more has negative contribution. How do I display percentage contributions?” I’ve gotten enough queries about it that I don’t want to keep explaining it. Hence this article. Before I talk about that, here’s the back story why I wrote the original article. If you want to know the display solution, skip ahead.

A few years ago, I was working in a team, whose most important project then dealt with revenue sharing. Our company offered a service, but we don’t have content (ring tones, movies, tv shows). The content providers have content, but don’t have marketing and distribution leverage. So partnerships formed.

What happened was customers signed up with us (the company I worked for), getting the content they want. Monthly subscriptions (television shows) and one-time payments (pay per view, ring tones). We charged the customers for the content use. Then we split the profit with the content providers, in a process we termed as “settlement“.

My users (the company product manager and team) used to have only an Excel spreadsheet to help. That was when the split was simple, like 30/70 (we get 30%, content provider gets 70%). Then the number of content providers grew, and certain rules came in (like minimum payment. I’ll talk about this in a bit), and the users needed help. So they contacted us (my department was IT support for the billing departments).

“Ok, so where are the negative numbers?” you ask. “None of the values should ever be negative.”

I hear you. My experience in the billing department also taught me that just because a number is positive, doesn’t mean it’s good. My very first task in the job was look at financial reports. In particular, financial reports on debt. All the numbers were positive. But they were all debt. I’ve seen debt sum totals of 8 digits. It’s scary, and it’s also made me a little blasé about money. It’s not that I hate money or don’t care about money, just that big figures don’t shock me as much (hey I still need to eat).

Anyway, back to the content provider story. The typical situation for a negative number is adjustments. For whatever reason, we’ve paid out more to the content provider than was correct (a waiver, a price change we didn’t detect, a product was retracted before we could do something). So in the next settlement cycle, we put in the adjustment, effectively reducing the amount we pay to them to adjust for the “mistake” for the last settlement cycle.

Let’s talk about minimum payment, to show you how complicated the settlement process could be. It’s a business rule that some of the content providers want. If for a particular month, the profit for them is below a certain number, don’t bother sharing with them. Accumulate the profit, rolling it over to future months until it hits the minimum requirement, and then send them the profit.

Why would content providers not want profit as soon as possible? Usually as part of the minimum payment rule, they get the minimum payment profit share in the first month. Let me give you an example, say the minimum payment is $400 and that the sharing is 50/50. In the first settlement month, we will pay out at least $200 to them, regardless of the number of customers signing up for the service. Of course, if the profit to them is more than $200, we pay out more too. So if the content wasn’t doing well, at least the content provider had some cash (which was guaranteed by the minimum payment) coming in on the first month. There are other reasons, such as the company is too big to want profits of low digits every month (!?!?! Yes, it happens…).

There are other business rules too. Such as withholding tax. What happens if the content provider is foreign (that is, non-Singaporean)? And there’s local tax (there was a transition from 3% to 4%, to 5% and to the now current 7% tax, the GST or Goods and Services Tax in Singapore).

The whole point is that the settlement process became fairly complicated (remember it started out as an Excel spreadsheet). So, well, uh, mistakes could happened (and did). Let’s just say I helped the user with correcting the data using Excel and database update statements. These corrections weren’t “standard” enough so they couldn’t be programmed into the settlement software. I became quite good in Excel data manipulation. Let me preempt you. I’m not manipulating numbers in the sense of fraud. It’s because the adjustment input/data couldn’t be easily added as part of the standard input process. I’m hijacking the process so that all the data required is correct and is there for the settlement calculations to do its job. The first few days of the month were always exciting for me (millions of database records, close deadline, Excel files flitting between me and the user). So to correct the wrong numbers in previous cycles, adjustments were made for the current cycle.

To make things even more complicated, the content providers want a breakdown of their profit by products. For example, if SonicToons received a profit (after the settlement split) of $120, they wanted to know that HotJamming made them $60, CrystalMood $40, and ViolinClassics $20. For analysis purposes, this meant the product HotJamming was hot, so they should make more products like that.

If you add negative numbers to that mix, it gets fun mighty soon. Do you set the negative numbers as a separate item? Do you split the negative value among all the products? It’s just hard. And so, that’s the reason I wrote the percentage calculation article, because the users (and the content providers) wanted a breakdown of the various product’s profit contribution.

So somewhere in that period of working on the project, my colleague asked me to help with formulating the rules of calculation. You know, because I studied maths and all. One of his problems was assigning the last single cent being shared among the products. I told him the solution took up an entire semester’s work (it’s called operations research) in university. He was stunned. Then I gave him a simpler alternate solution. This article is already very long, so I’ll tell you that solution in a later article.

The display solution

Well, you made it. You’ve skipped over several hundred words of back story. Congratulations! Let me expand on the general question first. Your company has two products. Product A made a profit of $200, and product B has a loss of $300. So in total, your company lost $100 ($200 – $300).

According to the calculation method in my original article, the percentage contributions for each product is as follows:
Product A contributed abs(200) / ( abs(200) + abs(-300) ) * 100% = 40%
Product B contributed abs(-300) / ( abs(200) + abs(-300) ) * 100% = 60%

So product A and product B contributed 40% and 60% respectively to your company’s bottom line.

The confusion of the commenters to that article and the readers who emailed me sets in. How can product B, clearly a bad investment, be contributing more?

The confusion is due to the business terms pre-assigned to the values. I will assume that you want your company’s bottom line to be of growth. However, that doesn’t mean the term assigned to it has to be “growth”. Of course, it didn’t help that “percentage contribution” implied a positive aspect.

For example, you don’t state in the business report:
Net gain = $200

That can be a line in the report, or an Excel column. I will suggest a slight change in terms.
Net change = $200

Or even just
Net = $200

You don’t have to use the word “change”, but it should be something neutral without proposing a positive or negative direction. So “change” is better than “growth”, “gain”, or “loss”. But don’t use “net delta” either. They won’t understand it…

“Net profit” is complicated. The reader of your report should be open to the idea that a number under “net profit” can be negative. The word “profit” typically invokes a positive growth mindset. But if your report’s readers (or the accounting department dictates it to be so) are ok with it, then go ahead and use that.

So in interpreting our example, product A contributed 40% to the net change. Yes, it’s a positive growth (+$200), but it’s just not positive enough. Product B contributed 60% to the net change. Because it’s a negative (-$300), and it’s the highest contributor, it caused the net to be a loss.

A blog reader, Jasper recently emailed me on this. Here’s an extract from my reply:

In terms of rewarding growth samples and punishing loss samples, calculate the percentage contributions as above. Then separate the samples by the sign of their original numbers, then sort by percentages. Let me illustrate:

Growth samples (positive sign)
2 (20%)

Loss samples (negative sign)
-4 (40%)
-3 (30%)
-1 (10%)

This way, you can see which samples do well, and which didn’t. So even though -4 contributed the most (40%), it’s a bad sample because it’s negative.

Don’t pre-assign terms to the values in the business report. Let the values (and the sign of the values) speak for themselves.